The Price Of Platinum Must Rise - Position Yourself Accordingly

Conditions surrounding platinum have been changing quickly, as extreme pressure is on the sector because the current price literally can't support the industry. Either the price of platinum will have to rise or production and supply will be cut back on. It's as simple a story as that, although with numerous details which support the narrative.

As for platinum supply, South Africa, Zimbabwe and Russia account for 90 percent of all platinum produced in the world, with South Africa accounting for about 75 percent to 80 percent of it.

Russia and Zimbabwe are largely non-players at this time, and probably won't have much impact on the platinum market for another decade. Zimbabwe is even questionable in that timeframe for political reasons, with the industry de-capitalizing itself after the rise of Robert Mugabe to power. The reason I say Zimbabwe may not be a player in platinum for even longer is it's uncertain what will happen after the death of Mugabe. The inevitable battle for power could paralyze the platinum industry for years in the country.

So in the near term, the story of platinum will be the story of what happens in South Africa, and that's where we must follow the action.

Short-Term Price Move

Before we get into the details of the long-term outlook for platinum, let's take a quick look at forces that could push the price of platinum up quickly.

That would give a temporary boost to platinum prices, as well as push the price of platinum up in the years ahead. That's because of the resultant supply deficit that will occur in response to the actions of the company. Being the largest platinum producer in the world, it could have a dramatic effect on the price movement of the metal. Coupled with gold bringing down the overall commodity sector, this could bring some nice returns in the near term.

The short-term risk is if in response an increase in secondary supply comes about, which could negate the actions of ANGLO American. Secondary supply refers to recycling, which has been a strong source of platinum, accounting for close to 30 percent of all platinum supply, while growing at a 50 percent (total supply) clip over the last decade.

For a potentially quick upward move in platinum prices, follow the actions of ANGLO American. As a matter of fact, that's also a long-term play as well, with the rewards being further down the road.

I'm not saying to invest in ANGLO American, I'm saying to follow its actions concerning whether it's going to hold back platinum or not.

Platinum Demand

The story of platinum demand is one easy to identify and understand. As Rick Rule of Sprott Asset Management recently said, "Platinum and palladium go out a tailpipe, go up a smokestack or get turned into jewelry - that's what happens to it."

So the demand equation is one of whether or not an investor believes any of those three markets are going to diminish any time soon. The only one that possibly could is the jewelry market. That conclusion is made based upon the rise in price of gold and the response of India and China to that in regard to acquiring jewelry. People started substituting silver, and in some cases platinum (when it was lower in price) for gold jewelry. That could also happen with platinum when it starts to rise in price.

But platinum is moved more by the auto and industrial sector, and that will remain true long into the future.

Platinum Supply and Meeting "Cost of Capital"

Citing Rick Rule again, he says the South African platinum industry "does not meet its cost of capital."

That of course presents a gigantic problem in the industry. If platinum at present prices can only be produced at a loss, there effectively really isn't a platinum industry.

Investors no longer see investing in platinum as worth the risk. Until the price of platinum goes up, that will remain the case. This is why ANGLO American wants to take platinum off the market, so constraints will boost the price and it can hopefully operate with a profit.

There really aren't any other alternatives, as the capital markets have dried up for precious metals companies, making borrowing very unlikely.

This is why unless there is a huge influx of alternative supply, we should see platinum availability shrink, which will ultimately raise the price. Other than that, mine production will continue to shrink. Companies simply cannot mine platinum and make money at these price levels.

One important thing to keep in mind while talking of platinum, is we're not talking about a scenario that is just beginning to emerge, we're talking one that has been going on for five or six years. We're not looking for something to happen, it has been happening, as evidenced by the drop in platinum production by 19 percent over the last six years.

Higher costs have already led to a drop in production, and will continue to do so until something changes.

By the estimates of the industry, it would take up to $8 billion in capital investment just to maintain the production levels of today. Suffering losses for several years means that type of capital isn't available.

What that means is platinum supply will remained constrained for years. There is no other alternative but for prices to go up.

This comes on the heels of seven straight years of platinum surpluses, ending in 2012 with a small deficit. That should be the case going forward, with the already stated caveat of a rise in recycling, which appears to be slowing down, as estimates are in 2012 the recycling of platinum fell 11 percent.

Mining Costs

There are two major elements driving the costs of mining in South Africa: labor and power.

Part of the problem of labor costs is the thin platinum ore deposits being mined. In that regard using machinery to mine is economically unfeasible, while at the same time resistance to mining machinery has become political as well, with extreme pressure in place to use manual labor to maintain jobs. Those pressures have made over 50 percent of the shafts mined to operate at a loss.

Consequently, the fact companies can't meet the cost of capital, means union demands for higher wages can't be met, even if there was strong will to make it happen.

So unions continue to threaten to walk out, a tactic that resulted in drop of 12 percent in refined mine production in 2012. Add to that two unions battling it out for supremacy, and you can see how complicated the picture in South Africa is.

Power Costs

As with most things in South Africa, power isn't as simple as it should or could be either. That's because of the monopoly held by Eskom, the national power company of South Africa, which produces 95 percent of the power in the country.

There is also a political mandate for Eskom to provide inexpensive power to those in the country who can't afford it.

Where is the power cut when there isn't enough to go around? It is the miners first. This is why interruptions in the mining industry in general in South Africa are a regular occurrence, including the platinum industry.

This disastrous and limited power grid shows no hint at improving, as there have been no upgrades for over 12 years, even while demand continues to rise.

So mining companies pay more for power, while being the first to be limited and/or cut off when others need it.

Essentially, the mining companies are underwriting a power grid that is having nothing done to expand capacity, even while energy demand surges. These costs could continue to rise, making it even less viable to successfully mine platinum in South Africa.

And it looks like it's going to get worse in the short term. Up to 25 percent of Eskom's overall capacity may not be accessible because of maintenance work planned in 2013. That could close more mines as the year proceeds.

Something Must Give

Unless you believe the auto and industrial sectors won't be using platinum going forward, you can see there are forces at work which must give sooner or later. Platinum is in huge demand, and the industry in shambles as far as profitably bringing new product to the market.

That not only suggests, but requires the price of platinum to rise if supply will be able to keep up with demand.

About the only major event that could happen to diminish demand in a meaningful way would be if new car sales were to plummet. Other than that, there is little to point to that could disrupt the sector.

Platinum jewelry was already mentioned, but demand there is expected to rise, and even if higher prices caused demand to fall there, it wouldn't be near as big of an impact as a significant drop in the auto industry.

Miners can't continue to operate at a loss, and that means, again, that either platinum prices go up or supply will go down.

Why am I so adamant about the price of platinum will rise? Think of the trade-off and you'll see it easily. Platinum is basically a producer of clean air, measured against the inevitable smog that comes from it not being part of autos or the smokestack industry. Does anyone seriously believe demand won't continue on based upon that reality?

That means a higher platinum price won't have any major impact on demand. To get the air quality we in North America and Western Europe enjoy, it costs about $200 of PGMs at current prices. When measured against a new car, which averages about $27,400, that's very minimal, even if the price of platinum were to double.

Investment Implications

There are a number of ETPs with a platinum focus, but I don't see why any investors should put their capital in any other fund than the ETFS Physical Platinum Shares (NYSEARCA:PPLT).

This particular fund is backed by physical platinum bars stored in Zurich and London vaults. The purpose of the fund is to "reflect the performance of the price of physical platinum."

ETFS Physical Platinum Shares

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At this time I see it superior to other ETPs platinum funds such as UBS E-TRACS CMCI Long Platinum Total Return ETN (NYSEARCA:PTM), iPath Dow Jones-AIG Platinum Total Return Sub-Index ETN (NYSEARCA:PGM), UBS E-TRACS CMCI Short Platinum Excess Return ETN (NYSEARCA:PTD), and VelocityShares 2x Long Platinum ETN (NASDAQ:LPLT).

These latter funds track the price of platinum, and the volume as of this writing are at very low levels.

What About Anglo American Platinum?

Anglo American is the largest platinum miner in the world. Will the eventual boost in platinum prices make them an attractive holding? I would say definitely not at this time.

Since it is the largest platinum miner, operating in one of the more volatile areas of the world, there is simply no predictability as to where the company will be in the near or long term.

Anglo American

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Its first order of business will be to do what it can to raise the price of platinum. If its strategy of holding platinum works, that will be the first step forward.

But the nature and volatility of the market at this time means Anglo American, or any other miner in South Africa, doesn't offer the risk-reward scenario investors want. This isn't going to change any time soon, so I would stick solely with an investment vehicle targeting the price movement of platinum.

Companies like Anglo American could be candidates for very short forays into the industry, but I wouldn't keep my money long in any company with exposure to South African platinum mining.

Conclusion

The fundamentals of platinum look very good at this time, as related to price, and this is the one predicable element in the industry.

All of this is predicated upon the fact the industry continues to lose money, and it can't continue to produce platinum under these conditions. There will either be a cut back in production, or supply will simply shrink until the price moves up.

In the past a robust recycling business provided some of the slack in the industry, but last year was the first time in seven years that reversed direction, and that provides even more support to the thesis platinum prices are ready to soar.

No matter which way I and others look at it, it seems there is nothing to hold back the price of platinum jumping, and investors positioning themselves at these entry points should do well.

As for the short term, as mentioned earlier, look at Anglo American and what it does in holding platinum back. If it does, that's potentially a terrific short-term play.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.